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Contents

FOREWORD iii

Chapter 1 Introduction to Accounting 1

1.1 Meaning of Accounting 2

1.2 Accounting as a Source of Information 6

1.3 Objectives of Accounting 10

1.4 Role of Accounting 13

1.5 Basic Terms in Accounting 14

Chapter 2 Theory Base of Accounting 22

2.1 Generally Accepted Accounting Principles (GAAP) 23

2.2 Basic Accounting Concepts 24

2.3 Systems of Accounting 33

2.4 Basis of Accounting 34

2.5 Accounting Standards 35

Chapter 3 Recording of Transactions - I 41

3.1 Business Transactions and Source Document 41

3.2 Accounting Equation 45

3.3 Using Debit and Credit 47

3.4 Books of Original Entry 56

3.5 The Ledger 64

3.6 Posting from Journal 67

Chapter 4 Recording of Transactions - II 91

4.1 Cash Book 92

4.2 Purchases (Journal) Book 117

4.3 Purchases Return (Journal) Book 1194.4 Sales (Journal) Book 121

4.5 Sales Return (Journal) Book 123

4.6 Journal Proper 129

4.7 Balancing the Accounts 131
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Chapter 5 Bank Reconciliation Statement 150

5.1 Need for Reconciliation 151

5.2 Preparation of Bank Reconciliation Statement 156

Chapter 6 Trial Balance and Rectification of Errors 181

6.1 Meaning of Trial Balance 181

6.2 Objectives of Preparing the Trial Balance 182

6.3 Preparation of Trial Balance 185

6.4 Significance of Agreement of Trial Balance 190

6.5 Searching of Errors 192

6.6 Rectification of Errors 193

Chapter 7 Depreciation, Provisions and Reserves 227

7.1 Depreciation 227

7.2 Depreciation and other Similar Terms 231

7.3 Causes of Depreciation 231

7.4 Need for Depreciation 232

7.5 Factors Affecting the Amount of Depreciation 234

7.6 Methods of calculating Depreciation Amount 235

7.7 Straight Line Method and Written Down Method 240A Comparative Analysis

7.8 Methods of Recording Depreciation 242

7.9 Disposal of Asset 251

7.10 Effect of any Addition or Extension to the 261Existing Asset

7.11 Provisions 264

7.12 Reserves 266

7.13 Secret Reserve 270

Chapter 8 Bill of Exchange 279

8.1 Meaning of Bill of Exchange 280

8.2 Promissory Note 282

8.3 Advantages of Bill of Exchange 284

8.4 Maturity of Bill 285

8.5 Discounting of Bill 285

8.6 Endorsement of Bill 286

8.7 Accounting Treatment 286

8.8 Dishonour of a Bill 293

8.9 Renewal of the Bill 298

8.10 Retiring of the Bill 301

8.11 Bills Receivable and Bills Payable Books 303

8.12 Accommodation of Bills 317
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AccountancyFinancial Accounting

Volume I

Textbook for Class XI


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LEARNINGOBJECTIVES

After studying this chapter

you will be able to:

state the meaning and

need of accounting;

discuss accounting as

a source of information ;

identify the internal

and external users of

accounting information;

explain the objectives

of accounting;

describe the role of

accounting;

explain the basic terms

used in accounting.

Over the centuries, accounting has remainedconfined to the financial record-keepingfunctions of the accountant. But, todays rapidlychanging business environment has forced theaccountants to reassess their roles and functions

both within the organisation and the society. Therole of an accountant has now shifted from that ofa mere recorder of transactions to that of themember providing relevant information to thedecision-making team. Broadly speaking,accounting today is much more than just book-

keeping and the preparation of financial reports.Accountants are now capable of working in excitingnew growth areas such as: forensic accounting(solving crimes such as computer hacking and thetheft of large amounts of money on the internet); e-commerce (designing web-based payment system);financial planning, environmental accounting, etc.

This realisation came due to the fact that accountingis capable of providing the kind of information thatmanagers and other interested persons need inorder to make better decisions. This aspect ofaccounting gradually assumed so much importancethat it has now been raised to the level of aninformation system. As an information system, itcollects data and communicates economicinformation about the organisation to a wide varietyof users whose decisions and actions are related toits performance. This introductory chapter

therefore, deals with the nature, need and scope of

accounting in this context.

Introduction to Accounting 1


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2 Accountancy

1.1 Meaning of Accounting

In 1941, The American Institute of Certified Public Accountants (AICPA) haddefined accounting as the art of recording, classifying, and summarising in asignificant manner and in terms of money, transactions and events which

are, in part at least, of financial character, and interpreting the results thereof.

With greater economic development resulting in changing role of accounting,its scope, became broader. In 1966, the American Accounting Association(AAA) defined accounting as the process of identifying, measuring andcommunicating economic information to permit informed judgments anddecisions by users of information.

In 1970, the Accounting Principles Board of AICPA also emphasised thatthe function of accounting is to provide quantitative information, primarily

financial in nature, about economic entities, that is intended to be useful inmaking economic decisions.

Accounting can therefore be defined as the process of identifying,measuring, recording and communicating the required information relatingto the economic events of an organisation to the interested users of such

Fig. 1.1 : Showing the process of accounting


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3Introduction to Accounting

information. In order to appreciate the exact nature of accounting, we mustunderstand the following relevant aspects of the definition:

Economic Events Identification, Measurement, Recording and Communication

Organisation Interested Users of Information

Box 1

History and Development of Accounting

Accounting enjoys a remarkable heritage. The history of accounting is as old ascivilisation. The seeds of accounting were most likely first sown in Babylonia andEgypt around 4000 B.C. who recorded transactions of payment of wages and taxeson clay tablets. Historical evidences reveal that Egyptians used some form ofaccounting for their treasuries where gold and other valuables were kept. The inchargeof treasuries had to send day wise reports to their superiors known as Wazirs (theprime minister) and from there month wise reports were sent to kings. Babylonia,known as the city of commerce, used accounting for business to uncover lossestaken place due to frauds and lack of efficiency. In Greece, accounting was used forapportioning the revenues received among treasuries, maintaining total receipts,total payments and balance of government financial transactions. Romans usedmemorandum or daybook where in receipts and payments were recorded andwherefrom they were posted to ledgers on monthly basis. (700 B.C to 400 A.D).

China used sophisticated form of government accounting as early as 2000 B.C.Accounting practices in India could be traced back to a period when twenty threecenturies ago, Kautilya, a minister in Chandraguptas kingdom wrote a book namedArthashasthra, which also described how accounting records had to be maintained.

Luca Paciolis, a Franciscan friar (merchant class), book Summa deArithmetica, Geometria, Proportion at Proportionality (Review of Arithmetic and Geometricproportions) in Venice (1494) is considered as the first book on double entry book-keeping. A portion of this book contains knowledge of business and book-keeping.However, Pacioli did not claim that he was the inventor of double entry book-keepingbut spread the knowledge of it. It shows that he probably relied on thencurrentbook-keeping manuals as the basis for his masterpiece. In his book, he used thepresent day popular terms of accounting Debit (Dr.) and Credit (Cr.). These were theconcepts used in Italian terminology. Debit comes from the Italian debitowhich comesfrom the Latin debitaand debeowhich means owed to the proprietor. Credit comes

from the Italian creditowhich comes from the Latin credo which means trust or belief(in the proprietor or owed by the proprietor. In explaining double entry system, Pacioliwrote that All entries have to be double entries, that is if you make one creditor, youmust make some debtor. He also stated that a merchants responsibility include togive glory to God in their enterprises, to be ethical in all business activities and toearn a profit. He discussed the details of memorandum, journal, ledger and specialisedaccounting procedures.


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4 Accountancy

1.1.1 Economic Events

Business organisations involves economic events. An economic event is knownas a happening of consequence to a business organisation which consists oftransactions and which are measurable in monetary terms. For example,purchase of machinery, installing and keeping it ready for manufacturing isan event which comprises number of financial transactions such as buying amachine, transportation of machine, site preparation for installation of amachine, expenditure incurred on its installation and trial runs. Thus,accounting identifies bunch of transactions relating to an economic event. Ifan event involves transactions between an outsider and an organisation, these

are known as external events. The following are the examples of suchtransactions:

Sale of Reebok shoes to the customers. Rendering services to the customers by Videocon Limited.

Purchase of materials from suppliers. Payment of monthly rent to the landlord.

An internal event isan economic event that occurs entirely between theinternal wings of an enterprise, e.g., supply of raw material or components bythe stores department to the manufacturing department, payment of wages

to the employees, etc.

1.1.2 Identification, Measurement, Recording and CommunicationIdentification : It means determining what transactions to record, i.e., to identityevents which are to be recorded. It involves observing activities and selecting

those events that are of considered financial character and relate to the

organisation. The business transactions and other economic events therefore

are evaluated for deciding whether it has to be recorded in books of account.

For example, the value of human resources, changes in managerial policies

or appointment of personnel are important but none of these are recorded in

books of account. However, when a company makes a sale or purchase, whether

on cash or credit, or pays salary it is recorded in the books of account.

Measurement : It means quantification (including estimates) of business

transactions into financial terms by using monetary unit, viz. rupees andpaise as a measuring unit. If an event cannot be quantified in monetary

terms, it is not considered for recording in financial accounts. That is why

important items like the appointment of a new managing director, signing of

contracts or changes in personnel are not shown in the books of accounts.

Recording: Once the economic events are identified and measured in financial

terms, these are recorded in books of account in monetary terms and in a

chronological order. Recording is done in a manner that the necessary financial


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information is summarised as per well-established practice and is made

available as and when required.

Communication:The economic events are identified, measured and recorded

in order that the pertinent information is generated and communicated in a

certain form to management and other internal and external users. The

information is regularly communicated through accounting reports. These

reports provide information that are useful to a variety of users who have an

interest in assessing the financial performance and the position of an

enterprise, planning and controlling business activities and making necessary

decisions from time to time. The accounting information system should be

designed in such a way that the right information is communicated to theright person at the right time. Reports can be daily, weekly, monthly, or

quarterly, depending upon the needs of the users. An important element in

the communication process is the accountants ability and efficiency in

presenting the relevant information.

1.1.3 Organisation

Organisationrefers to a business enterprise, whether for profit or not-for-

profit motive. Depending upon the size of activities and level of business

operation, it can be a sole-proprietory concern, partnership firm, cooperative

society, company, local authority, municipal corporation or any other

association of persons.

1.1.4 Interested Users of Information

Accounting is a means by which necessary financial information aboutbusiness enterprise is communicated and is also called the language ofbusiness. Many users need financial information in order to make importantdecisions. These users can be divided into two broad categories: internal usersand external users. Internal users include: Chief Executive, Financial Officer,

Vice President, Business Unit Managers, Plant Managers, Store Managers,Line Supervisors, etc. External users include: present and potential Investors(shareholders), Creditors (Banks and other Financial Institutions, Debenture-

holders and other Lenders), Tax Authorities, Regulatory Agencies (Departmentof Company Affairs, Registrar of Companies, Securities Exchange Board ofIndia, Labour Unions, Trade Associations, Stock Exchange and Customers,etc. Since the primary function of accounting is to provide useful informationfor decision-making, it is a means to an end, with the end being the decisionthat is helped by the availability of accounting information. You will studyabout the types of accounting information and its users later in this chapter.


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6 Accountancy

Box 2

Why do the Users Want Accounting Information?

The owners/shareholders use them to see if they are getting a satisfactory returnon their investment, and to assess the financial health of their company/business.

The directors/managers use them for making both internal and externalcomparisons in their attempts to evaluate the performance. They may comparethe financial analysis of their company with the industry figures in order toascertain the companys strengths and weaknesses. Management is alsoconcerned with ensuring that the money invested in the company/organisationis generating an adequate return and that the company/organisation is able topay its debts and remain solvent.

The creditors (lenders) want to know if they are likely to get paid and lookparticularly at liquidity, which is the ability of the company/organisation to payits debts as they become due.

The prospective investors use them to assess whether or not to invest theirmoney in the company/organisation.

The government and regulatory agencies such as Registrar of companies, Customdepartments IRDA, RBI, etc. require information for the payment of various taxessuch as Value Added Tax (VAT), Income Tax (IT), Customs and Excise duties forprotecting the interests of investors, creditors(lenders), and also to satisfy thelegal obligations imposed by the Companies Act 1956 and SEBI from time-to-time.

1.2 Accounting as a Source of Information

As discussed earlier, accounting is a definite processes of interlinked activities,(refer figure 1.1) that begins with the identification of transactions and ends

with the preparation of financial statements. Every step in the process ofaccounting generates information. Generation of information is not an endin itself. It is a means to facilitate the dissemination of information amongdifferent user groups. Such information enables the interested parties totake appropriate decisions. Therefore, dissemination of information is anessentialfunction of accounting. To be useful, the accounting information should

ensure to: provide information for making economic decisions;

serve the users who rely on financial statements as their principal sourceof information;

provide information useful for predicting and evaluating the amount,

timing and uncertainty of potential cash-flows;

provide information for judging managements ability to utilise resources

effectively in meeting goals;


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provide factual and interpretative information by disclosing underlying

assumptions on matters subject to interpretation, evaluation, prediction,

or estimation; and

provide information on activities affecting the society.

Test Your Understanding - I

Complete the following sentences with appropriate words:

(a) Information in financial reports is based on ..................... transactions.

(b) Internal users are the ..................... of the business entity.

(c) A ..................... would most likely use an entities financial report to determinewhether or not the business entity is eligible for a loan.

(d) The Internet has assisted in decreasing the ..................... in issuing financialreports to users.

(e) ..................... users are groups outside the business entity, who uses theinformation to make decisions about the business entity.

(f) Information is said to be relevent if it is ......................

(g) The process of accounting starts with ............ and ends with ............

(h) Accounting measures the business transactions in terms of ............ units.

(i) Identified and measured economic events should be recording in ............ order.

The role of an accountant in generating accounting information is to observe,screen and recognise events and transactions to measure and process them,

and thereby compile reports comprising accounting information that are

communicated to the users. These are then interpreted, decoded and used

by management and other user groups. It must be ensured that the information

provided is relevant, adequate and reliable for decision-making. The apparently

divergent needs of internal and external users of accounting information have

resulted in the development of sub-disciplines within the accounting discipline

namely,financial accounting, cost accounting and management accounting(refer

box 3).

Financial accounting assists keeping a systematic record of financial

transactions the preparation and presentation of financial reports in order to

arrive at a measure of organisational success and financial soundness. It

relates to the past period, serves the stewardshipfunction and is monetary in

nature. It is primarily concerned with the provision of financial information to

all stakeholders.

Cost accountingassists in analysing the expenditure for ascertaining the

cost of various products manufactured or services provided by the firm and


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8 Accountancy

fixation of prices thereof. It also helps in controlling the costs and providing

necessary costing information to management for decision-making.

Management accountingdeals with the provision of necessary accounting

information to people within the organisation to enable them in decision-making,

planning and controlling business operations. Management accounting draws

the relevant information mainly from financial accounting and cost accounting

which helps the management in budgeting, assessing profitability, taking pricing

decisions, capital expenditure decisions and so on. Besides, it generates other

information (quantitative and qualitative, financial and non-financial) which

relates to the future and is relevant for decision-making in the organisation.

Such information includes: sales forecast, cash flows, purchase requirement,

manpower needs, environmental data about effects on air, water, land, natural

resources, flora, fauna, human health, social responsibilities, etc.

As a result, the scope of accounting has become so vast, that new areas

like human resource accounting, social accounting, responsibility accounting

have also gained prominance.

Lets Do It

Many People in todays society think of an accountant as simply a glorified book-keeper. But the role of an accountant is continually changing. Discuss in the

classroom what really the role of accounting is?

1.2.1 Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes of accounting information whichtend to enhance its understandability and usefulness. In order to assess

whether accounting information is decision useful, it must possess the

characteristics of reliability, relevance, understandability and comparability.

Reliability

Reliability means the users must be able to depend on the information. Thereliability of accounting information is determined by the degree ofcorrespondence between what the information conveys about the transactionsor events that have occurred, measured and displayed. A reliable informationshould be free from error and bias and faithfully represents what it is meantto represent. To ensure reliability, the information disclosed must be credible,

verifiable by independent parties use the same method of measuring, and beneutral and faithful (refer figure 1.3).


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Box 3

Branches of Accounting

The economic development and technological improvements have resulted in anincrease in the scale of operations and the advent of the company form of businessorganisation. This has made the management function more and more complex andincreased the importance of accounting information. This gave rise to special branchesof accounting. These are briefly explained below :

Financial accounting :The purpose of this branch of accounting is to keep a recordof all financial transactions so that:(a) the profit earned or loss sustained by the business during an accounting period

can be worked out,(b) the financial position of the business as at the end of the accounting period

can be ascertained, and(c) the financial information required by the management and other interested

parties can be provided.

Cost Accounting :The purpose of cost accounting is to analyse the expenditure soas to ascertain the cost of various products manufactured by the firm and fix theprices. It also helps in controlling the costs and providing necessary costinginformation to management for decision-making.

Management Accounting :The purpose of management accounting is to assist themanagement in taking rational policy decisions and to evaluate the impact of itsdecisons and actions.

Relevance

To be relevant, information must be available in time, must help in predictionand feedback, and must influence the decisions of users by :

(a) helping them form prediction about the outcomes of past, present orfuture events; and/or

(b) confirming or correcting their past evaluations.

Understandability

Understandability means decision-makers must interpret accountinginformation in the same sense as it is prepared and conveyed to them. Thequalities that distinguish between good and bad communication in a messageare fundamental to the understandability of the message. A message is saidto be effectively communicated when it is interpreted by the receiver of themessage in the same sense in which the sender has sent. Accountants shouldpresent the comparable information in the most intenlligible manner withoutsacrificing relevance and reliability.


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10 Accountancy

Comparability

It is not sufficient that the financial information is relevant and reliable at aparticular time, in a particular circumstance or for a particular reporting entity.But it is equally important that the users of the general purpose financial reports

are able to compare various aspects of an entity over different time period andwith other entities. To be comparable, accounting reports must belong to acommon period and use common unit of measurement and format of reporting.

Test Your Understanding - II

You are a senior accountant of Ramona Enterprises Limited. What three steps wouldyou take to make your companys financial statements understandable and decisionuseful?

1.

2.

3.

[Hint : Refer to qualitative characteristics of accounting information]

1.3 Objectives of Accounting

As an information system, the basic objective of accounting is to provide useful

information to the interested group of users, both external and internal. The

necessary information, particularly in case of external users, is provided inthe form of financial statements, viz., profit and loss account and balance

sheet. Besides these, the management is provided with additional informationfrom time to time from the accounting records of business. Thus, the primaryobjectives of accounting include the following:

1.3.1 Maintenance of Records of Business Transactions

Accounting is used for the maintenance of a systematic record of all financialtransactions in book of accounts. Even the most brilliant executive or managercannot accurately remember the numerous amount of varied transactionssuch as purchases, sales, receipts, payments, etc. that takes place in businesseveryday. Hence, a proper and complete records of all business transactionsare kept regularly. Moreover, the recorded information enables verifiabilityand acts as an evidence.

1.3.2 Calculation of Profit and Loss

The owners of business are keen to have an idea about the net results of theirbusiness operations periodically, i.e. whether the business has earned profits


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or incurred losses. Thus, another objective of accounting is to ascertain theprofit earned or loss sustained by a business during an accounting period

which can be easily workout with help of record of incomes and expensesrelating to the business by preparing a profit or loss account for the period.Profit represents excess of revenue (income), over expenses. If the total revenueof a given period is Rs 6,00,000 and total expenses are Rs. 5,40,000 the profit

will be equal to Rs. 60,000(Rs. 6,00,000 Rs. 5,40,000). If however, the totalexpenses exceed the total revenue, the difference reflects the loss.

1.3.3 Depiction of Financial Position

Accounting also aims at ascertaining the financial position of the businessconcern in the form of its assets and liabilities at the end of every accountingperiod. A proper record of resources owned by business organisation (Assets)

Qualitative Characteristic of Accounting Information

Decision Makers(Users of Accounting Information)

Understandability

Decision Usefulness

Relevance Relability

Timliness

Dedicative Feedback Verifiability FaithfulnessValue Value

Nutrality

Comparability

Fig. 1.3 :The qualitative characteristics of accounting information


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12 Accountancy

and claims against such resources (Liabilities) facilitates the preparation of astatement known as balance sheet position statement.

1.3.4 Providing Accounting Information to its Users

The accounting information generated by the accounting process iscommunicated in the form of reports, statements, graphs and charts to theusers who need it in different decision situations. As already stated, there aretwo main user groups, viz. internal users, mainly management, who needstimely information on cost of sales, profitability, etc. for planning, controllingand decision-making and external userswho have limited authority, abilityand resources to obtain the necessary information and have to rely on financialstatements (Balance Sheet, Profit and Loss account). Primarily, the externalusers are interested in the following: Investors and potential investors-information on the risks and returns

on investments; Unions and employee groups-information on the stability, profitability

and distribution of wealth within the business; Lenders and financial institutions-information on the creditworthiness of

the company and its ability to repay loans and pay interest; Suppliers and creditors-information on whether amounts owed will be

repaid when due, and on the continued existence of the business; Customers-information on the continued existence of the business and

thus the probability of a continued supply of products, parts and aftersales service; Government and other regulators- information on the allocation of

resources and the compliance to regulations; Social responsibility groups, such as environmental groups-information

on the impact on environment and its protection; Competitors-information on the relative strengths and weaknesses of their

competition and for comparative and benchmarking purposes. Whereasthe above categories of users share in the wealth of the company,competitors require the information mainly for strategic purposes.

Test Your Understanding - III

Which stakeholder g roup Would be most interested in_____________________________ (a) the VAT and other tax liabilities of the firm_____________________________ (b) the potential for pay awards and bouns deals_____________________________ (c) the ethical or environmental activities of the firm_____________________________ (d) whether the firm has a long-term future_____________________________ (e) profitability and share performance_____________________________ (f) the ability of the firm to carry on providing a

service or producing a product.


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1.4 Role of Accounting

For centuries, the role of accounting has been changing with the changes ineconomic development and increasing societal demands. It describes andanalyses a mass of data of an enterprise through measurement, classificationand summarisation, and reduces those date into reports and statements,

which show the financial condition and results of operations of that enterprise.Hence,it is regarded as a language of business. It also performs the serviceactivity by providingquantitative financial information that helps the users in

various ways. Accounting as an information system collects and communicateseconomic information about an enterprise to a wide variety of interested parties.

However, accounting information relates to the past transactions and isquantitative and financial in nature, it does not provide qualitative and non-financial information. These limitations of accounting must be kept in view

while making use of the accounting information.

Test Your Understanding - IV

Tick the Correct Answer

1. Which of the following is not a business transaction?a. Bought furniture of Rs.10,000 for businessb. Paid for salaries of employees Rs.5,000c. Paid sons fees from his personal bank account Rs.20,000d. Paid sons fees from the business Rs.2,000

2. Deepti wants to buy a building for his business today. Which of the following is therelevant data for his decision?a. Similar business acquired the required building in 2000 for Rs. 10,00,000b. Building cost details of 2003c. Building cost details of 1998d. Similar building cost in August, 2005 Rs. 25,00,000

3. Which is the last step of accounting as a process of information?a. Recording of data in the books of accountsb. Preparation of summaries in the form of financial statementsc. Communication of informationd. Analysis and interpretation of information

4. Which qualitative characteristics of accounting information is reflected whenaccounting information is clearly presented?a. Understandability

b. Relevancec. Comparabilityd. Reliability

5. Use of common unit of measurement and common format of reporting promotes;a. Comparabilityb. Understandabilityc. Relevanced. Reliability


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14 Accountancy

Box 4

Different Roles of Accounting

As a language it is perceived as the language of business which is used tocommunicate information on enterprises;

As a historical record- it is viewed as chronological record of financial transactionsof an organisation at actual amounts involved;

As current economic reality- it is viewed as the means of determining the trueincome of an entity namely the change of wealth over time;

As an information system it is viewed as a process that links an informationsource (the accountant) to a set of receivers (external users) by means of a channel

of communication; As a commodity- specialised information is viewed as a service which is in demand

in society, with accountants being willing to and capable of providing it.

1.5 Basic Terms in Accounting

1.5.1 Entity

Entity means a thing that has a definite individual existence. Business entitymeans a specifically identifiable business enterprise like Super Bazaar, Hire

Jewellers, ITC Limited, etc. An accounting system is always devised for aspecific business entity (also called accounting entity).

1.5.2 Transaction

A event involving some value between two or more entities. It can be a purchaseof goods, receipt of money, payment to a creditor, incurring expenses, etc. It

can be a cash transaction or a credit transaction.

1.5.3 Assets

Assets are economic resources of an enterprise that can be usefully expressedin monetary terms. Assets are items of value used by the business in itsoperations. For example, Super Bazar owns a fleet of trucks, which is used byit for delivering foodstuffs; the trucks, thus, provide economic benefit to the

enterprise. This item will be shown on the asset side of the balance sheet ofSuper Bazaar. Assets can be broadly classified into two types: Fixed Assetsand Current Assets.

Fixed Assetsare assets held on a long-term basis, such as land, buildings,

machinery, plant, furniture and fixtures. These assets are used for the normal

operations of the business.


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Current Assets are assets held on a short-term basis such asdebtors(accounts receivable), bills receivable (notes receivable), stock(inventory), temporary marketable securities, cash and bank balances.

1.5.4 Liabilities

Liabilities are obligations or debts that an enterprise has to pay at some timein the future. They represent creditors claims on the firms assets. Both smalland big businesses find it necessary to borrow money at one time or the other,and to purchase goods on credit. Super Bazar, for example, purchases goodsfor Rs. 10,000 on credit for a month from Fast Food Products on March 25,

2005. If the balance sheet of Super Bazaar is prepared as at March 31, 2005,Fast Food Products will be shown as creditors on the liabilities side of the

balance sheet. If Super Bazaar takes a loan for a period of three years fromDelhi State Co-operative Bank, this will also be shown as a liability in the

balance sheet of Super Bazaar. Liabilities are classified as long-term liabilitiesand short-term liabilities (also known as short-term liabilities).

Long-term liabilities are those that are usually payable after a period ofone year, for example, a term loan from a financial institution or debentures(bonds) issued by a company.

Short-term liabilitiesare obligations that are payable within a period of oneyear, for example, creditors, bills payable, bank overdraft.

1.5.5 Capital

Amount invested by the owner in the firm is known as capital. It may bebrought in the form of cash or assets by the owner for the business entitycapital is an obligation and a claim on the assets of business. It is, therefore,shown as capital on the liabilities side of the balance sheet.

1.5.6 Sales

Sales are total revenues from goods or services sold or provided to customers.Sales may be cash sales or credit sales.

1.5.7 Revenues

These are the amounts of the business earned by selling its products orproviding services to customers, called sales revenue. Other items of revenuecommon to many businesses are: commission, interest, dividends, royalities,rent received, etc. Revenue is also called income.


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16 Accountancy

1.5.8 Expenses

Costs incurred by a business in the process of earning revenue are known asexpenses. Generally, expenses are measured by the cost of assets consumedor services used during an accounting period. The usual items of expensesare: depreciation, rent, wages, salaries, interest, cost of heater, light and water,telephone, etc.

1.5.9 Expenditure

Spending money or incurring a liability for some benefit, service or propertyreceived is called expenditure. Payment of rent, salary, purchase of goods,purchase of machinery, purchase of furniture, etc. are examples of expenditure.If the benefit of expenditure is exhausted within a year, it is treated as anexpense (also called revenue expenditure). On the other hand, the benefit ofan expenditure lasts for more than a year, it is treated as an asset (also calledcapital expenditure) such as purchase of machinery, furniture, etc.

1.5.10 Profit

The excess of revenues of a period over its related expenses during anaccounting year profit. Profit increases the investment of the owners.

1.5.11 Gain

A profit that arises from events or transactions which are incidental to businesssuch as sale of fixed assets, winning a court case, appreciation in the value ofan asset.

1.5.12 Loss

The excess of expenses of a period over its related revenues its termed as loss.It decreases in owners equity. It also refers to money or moneys worth lost(or cost incurred) without receiving any benefit in return, e.g., cash or goodslost by theft or a fire accident, etc. It also includes loss on sale of fixed assets.

1.5.13 Discount

Discount is the deduction in the price of the goods sold. It is offered in twoways. Offering deduction of agreed percentage of list price at the time sellinggoods is one way of giving discount. Such discount is called trade discount.It is generally offered by manufactures to wholesellers and by wholesellers toretailers. After selling the goods on credit basis the debtors may be givencertain deduction in amount due in case if they pay the amount within thestipulated period or earlier. This deduction is given at the time of payment on


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the amount payable. Hence, it is called as cash discount. Cash discount actsas an incentive that encourages prompt payment by the debtors.

1.5.14 Voucher

The documentary evidence in support of a transaction is known as voucher.For example, if we buy goods for cash, we get cash memo, if we buy on credit,

we get an invoice; when we make a payment we get a receipt and so on.

1.5.15 Goods

It refers to the products in which the business units is dealing, i.e. in terms of

which it is buying and selling or producting and selling. The items that arepurchased for use in the business are not called goods. For example, for afurniture dealer purchase of chairs and tables is termed as goods, while forother it is furniture and is treated as an asset. Similarly, for a stationery merchant,stationery is goods, whereas for others it is an item of expense (not purchases)

1.5.16 Drawings

Withdrawal of money and/or goods by the owner from the business for personaluse is known as drawings. Drawings reduces the investment of the owners.

1.5.17 Purchases

Purchases are total amount of goods procured by a business on credit and oncash, for use or sale. In a trading concern, purchases are made of merchandisefor resale with or without processing. In a manufacturing concern, rawmaterials are purchased, processed further into finished goods and then sold.Purchases may be cash purchases or credit purchases.

1.5.18 Stock

Stock (inventory) is a measure of something on hand-goods, spares and otheritems in a business. It is called Stock in hand. In a trading concern, the stockon hand is the amount of goods which are lying unsold as at the end of anaccounting period is called closing stock (ending inventory). In a manufacturing

company, closing stock comprises raw materials, semi-finished goods andfinished goods on hand on the closing date. Similarly, opening stock(beginninginventory) is the amount of stock at the beginning of the accounting period.

1.5.19 Debtors

Debtors are persons and/or other entities who owe to an enterprise an amountfor buying goods and services on credit. The total amount standing against


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18 Accountancy

such persons and/or entities on the closing date, is shown in the balancesheet as sundry debtorson the asset side.

1.5.20 Creditors

Creditors are persons and/or other entities who have to be paid by an enterprise

an amount for providing the enterprise goods and services on credit. The totalamount standing to the favour of such persons and/or entities on the closingdate, is shown in the Balance Sheet as sundry creditorson the liabilities side.

Test Your Understanding - V

Mr. Sunrise started a business for buying and selling of stationery with Rs. 5,00,000as an initial investment. Of which he paid Rs.1,00,000 for furniture, Rs. 2,00,000for buying stationery items. He employed a sales person and clerk. At the end of themonth he paid Rs.5,000 as their salaries. Out of the stationery bought he sold somestationery for Rs.1,50,000 for cash and some other stationery for Rs.1,00,000 oncredit basis to Mr.Ravi. Subsequently, he bought stationery items of Rs.1,50,000from Mr. Peace. In the first week of next month there was a fire accident and he lostRs. 30,000 worth of stationery. A part of the machinery, which cost Rs. 40,000, wassold for Rs. 45,000.

From the above, answer the following :

1. What is the amount of capital with which Mr. Sunrise started business.

2. What are the fixed assets he bought?

3. What is the value of the goods purchased?

4. Who is the creditor and state the amount payable to him?

5. What are the expenses?

6. What is the gain he earned?

7. What is the loss he incurred?

8. Who is the debtor? What is the amount receivable from him?

9. What is the total amount of expenses and losses incurred?

10. Determine if the following are assets, liabilities, revenues, expenses or none ofthe these: sales, debtors, creditors, salary to manager, discount to debtors,drawings by the owner.

Summary with Reference to Learning Objectives

1. Meaning of Accounting : Accounting is a process of identifying, measuring,recording the business transactions and communicating thereof the required

information to the interested users.

2. Accounting as a source of information: Accounting as a source of informationsystem is the process of identifying, measuring, recording and communicating

the economic events of an organisation to interested users of the information.


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3. Users of accounting information: Accounting plays a significant role in society

by providing information to management at all levels and to those having adirect financial interest in the enterprise, such as present and potential

investors and creditors. Accounting information is also important to those

having indirect financial interest, such as regulatory agencies, tax authorities,customers, labour unions, trade associations, stock exchanges and others.

4. Qualitative characteristics of Accounting : To make accounting information

decision useful, it should possess the following qualitative characteristics.

Reliability Understandability

Relevance Comparability

5. Objective of accounting: The primary objectives of accounting are to :

maintain records of business; calculate profit or loss; depict the financial position; and make information available to various groups and users.

6. Role of accounting : Accounting is not an end in itself. It is a means to an end.It plays the role of a :

Language of a business Historical record Current economic reality Information system Service to users

Questions for Practice

Short Answers

1. Define accounting.

2. State what is end product of financial accounting.

3. Enumerate main objectives of accounting.

4. List any five users who have indirect interest in accounting.

5. State the nature of accounting information required by long-term lenders.

6. Who are the external users of information?

7. Enumerate informational needs of management.

8. Give any three examples of revenues.

9. Distinguish between debtors and creditors.

10. Accounting information should be comparable. Do you agree with thisstatement. Give two reasons.

11. If the accounting information is not clearly presented, which of the qualitativecharacteristic of the accounting information is violated?

12. The role of accounting has changed over the period of time- Do you agree?Explain.

13. Giving examples, explain each of the following accounting terms :

Fixed assets Gain Profit Revenue Expenses Short-term liability Capital

14. How will you define revenues and expenses?


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20 Accountancy

15. What is the primiary reason for the business students and others tofamiliarise themselves with the accounting discipline?

Long Answers

1. Explain the factors, which necessitated systematic accounting.

2. Describe the brief history of accounting.

3. Explain the development of and role of accounting.

4. Define accounting and state its objectives.

5. Describe the informational needs of external users.

6. What do you mean by an asset and what are different types of assets?

7. Explain the meaning of gain and profit. Distinguish between these two terms.

8. Explain the qualitative characteristics of accounting information.9. Describe the role of accounting in the modern world.

Checklist to Test Your Understanding

Test Your Understanding I

(a) Economic (b) Management/Employees (c) Creditor

(d) Time-gap (e) External (f) Free from bias

(g) Identifying the transactions and communicating information

(h) Monetory (i) Chronological


1. Reliability, i.e. Verifiability, Faithfulness, Nutrality

2. Relevance, i.e. Timeliness3. Understandability and Comparibility

Test Your Understanding - III

(a) Government and other regulators

(b) Management

(c) Social responsibility groups

(d) Lenders

(e) Suppliers and Creditors

(f) Customers

Test Your Understanding - IV

1. (c) 2. (c) 3. (a) 4. (a) 5. (b) 6. (c) 7. (a) 8. (a) 9. (d)

Test Your Understanding - V

1. Rs. 5,00,000 2. Rs. 1,00,000, 3. Rs. 2,00,000

4. Mr. Reace, Rs. 1,50,000 5. Rs. 5,000 6. Rs. 5,000

7. Rs. 30,000 8. Mr. Ravi, Rs. 1,00,000 9. Rs. 35,000

10. Assets : debtors; Liabilities : creditors; drawings; Revenues : sales expenses,discount, salary.


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LEARNING OBJECTIVES

After studying this chapter,you will be able to:

identify the need for

theory base of acco-

unting;

explain the nature of

Generally Accepted

Accounting Principles

(GAAP);

describe the meaning

and purpose of the basic

accounting concepts;

enumerate the accounting

standards issued byInstitute of Chartered

Accountants of India;

describe the systems

of accounting; and

describe various basis

of accounting.

As discussed in the previous chapter, accounting

is concerned with the recording, classifying and

summarising of financial transactions and events

and interpreting the results thereof. It aims at

providing information about the financial

performance of a firm to its various users such as

owners, managers employees, investors, creditors,

suppliers of goods and services and tax authorities

and help them in taking important decisions. The

investors, for example, may be interested in

knowing the extent of profit or loss earned by the

firm during a given period and compare it with the

performance of other similar enterprises. The

suppliers of credit, say a banker, may, in addition,

be interested in liquidity position of the enterprise.

All these people look forward to accounting for

appropriate, useful and reliable information.

For making the accounting information

meaningful to its internal and external users, it is

important that such information is reliableas well

as comparable. The comparability of information is

required both to make inter-firmcomparisons, i.e.

to see how a firm has performed as compared to

the other firms, as well as to make inter-period

comparison, i.e. how it has performed as compared

to the previous years. This becomes possible only

if the information provided by the financial

statements is based on consistent accounting

policies, principles and practices. Such consistency

is required throughout the process of identifying

Theory Base of Accounting 2


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2 3Theory base of Accounting

the events and transactions to be accounted for, measuring them,

communicating them in the book of accounts, summarising the results thereof

and reporting them to the interested parties. This calls for developing a proper

theory base of accounting.

The importance of accounting theory need not be over-emphasised as no

discipline can develop without a sound theoretical base. The theory base of

accounting consists of principles, concepts, rules and guidelines developed

over a period of time to bring uniformity and consistency to the process of

accounting and enhance its utility to different users of accounting information.

Apart from these, the Institute of Chartered Accountants of India, (ICAI), which

is the regulatory body for standardisation of accounting policies in the countryhas issued Accounting Standards which are expected to be uniformly adhered

to, in order to bring consistency in the accounting practices. These are

discussed in the sections to follow.

2.1 Generally Accepted Accounting Principles (GAAP)

In order to maintain uniformity and consistency in accounting records, certain

rules or principles have been developed which are generally accepted by the

accounting profession. These rules are called by different names such as

principles, concepts, conventions, postulates, assumptions and modifying

principles.

The term principle has been defined by AICPA as A general law or rule

adopted or professed as a guide to action, a settled ground or basis of conduct

or practice. The word generally means in a general manner, i.e. pertaining

to many persons or cases or occasions. Thus, Generally Accepted Accounting

Principles (GAAP) refers to the rules or guidelines adopted for recording and

reporting of business transactions, in order to bring uniformity in the

preparation and the presentation of financial statements. For example, one of

the important rule is to record all transactions on the basis of historical cost,

which is verifiable from the documents such as cash receipt for the money

paid. This brings in objectivity in the process of recording and makes the

accounting statements more acceptable to various users.

The Generally Accepted Accounting Principles have evolved over a long

period of time on the basis of past experiences, usages or customs, statementsby individuals and professional bodies and regulations by government agencies

and have general acceptability among most accounting professionals. However,

the principles of accounting are not static in nature. These are constantly

influenced by changes in the legal, social and economic environment as well

as the needs of the users.


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2 4 Accountancy

These principles are also referred as concepts and conventions. The term

conceptrefers to the necessary assumptions and ideas which are fundamental

to accounting practice, and the term conventionconnotes customs or traditions

as a guide to the preparation of accounting statements. In practice, the same

rules or guidelines have been described by one author as a concept, by another

as a postulate and still by another as convention. This at times becomes

confusing to the learners. Instead of going into the semantics of these terms,

it is important to concentrate on the practicability of their usage. From the

practicability view point, it is observed that the various terms such as

principles, postulates, conventions, modifying principles, assumptions, etc.

have been used inter-changeably and are referred to as Basic AccountingConceptsin the present chapter.

2.2 Basic Accounting Concepts

The basic accounting concepts are referred to as the fundamental ideas or

basic assumptions underlying the theory and practice of financial accounting

and are broad working rules for all accounting activities and developed by the

accounting profession. The important concepts have been listed as below:

Business entity;

Money measurement;

Going concern;

Accounting period; Cost

Dual aspect (or Duality);

Revenue recognition (Realisation);

Matching;

Full disclosure;

Consistency; Conservatism (Prudence);

Materiality;

Objectivity.

2.2.1 Business Entity Concept

The concept of business entity assumes that businesshas a distinct and

separateentity from its owners. It means that for the purposes of accounting,

the business and its owners are to be treated as two separate entities. Keeping

this in view, when a person brings in some money as capital into his business,

in accounting records, it is treated as liability of the business to the owner.

Here, one separate entity (owner) is assumed to be giving money to another

distinct entity (business unit). Similarly, when the owner withdraws any moneyfrom the business for his personal expenses(drawings), it is treated as reduction

of the owners capital and consequently a reduction in the liabilities of the

business.

The accounting records are made in the book of accounts from the point of

view of the business unit and not that of the owner. The personal assets and


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liabilities of the owner are, therefore, not considered while recording and

reporting the assets and liabilities of the business. Similarly, personal

transactions of the owner are not recorded in the books of the business, unless

it involves inflow or outflow of business funds.

2.2.2 Money Measurement Concept

The concept of money measurement states that only those transactions and

happenings in an organisation which can be expressed in terms of money

such as sale of goods or payment of expenses or receipt of income, etc. are to

be recorded in the book of accounts. All such transactions or happeningswhich can not be expressed in monetary terms, for example, the appointment

of a manager, capabilities of its human resources or creativity of its research

department or image of the organisation among people in general do not find

a place in the accounting records of a firm.

Another important aspect of the concept of money measurement is that

the records of the transactions are to be kept not in the physical units but in

the monetary unit. For example, an organisation may, on a particular day,

have a factory on a piece of land measuring 2 acres, office building containing

10 rooms, 30 personal computers, 30 office chairs and tables, a bank balance

of Rs.5 lakh, raw material weighing 20-tons, and 100 cartons of finished goods.

These assets are expressed in different units, so can not be added to give any

meaningful information about the total worth of business. For accounting

purposes, therefore, these are shown in money terms and recorded in rupees

and paise. In this case, the cost of factory land may be say Rs. 2 crore; office

building Rs. 1 crore; computers Rs.15 lakh; office chairs and tables Rs. 2

lakh; raw material Rs. 33 lakh and finished goods Rs. 4 lakh. Thus, the total

assets of the enterprise are valued at Rs. 3 crore and 59 lakh. Similarly, all

transactions are recorded in rupees and paise as and when they take place.

The money measurement assumption is not free from limitations. Due to

the changes in prices, the value of money does not remain the same over a

period of time. The value of rupee today on account of rise in prices is much

less than what it was, say ten years back. Therefore, in the balance sheet,

when we add different assets bought at different points of time, say buildingpurchased in 1995 for Rs. 2 crore, and plant purchased in 2005 for Rs. 1

crore, we are in fact adding heterogeneous values, which can not be clubbed

together. As the change in the value of money is not reflected in the book of

accounts, the accounting data does not reflect the true and fair view of the

affairs of an enterprise.


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2 6 Accountancy

2.2.3 Going Concern Concept

The concept of going concernassumes that a business firm would continue to

carry out its operations indefinitely, i.e. for a fairly long period of time and

would not be liquidated in the foreseeable future. This is an important

assumption of accounting as it provides the very basis for showing the value

of assets in the balance sheet.

An asset may be defined as a bundle of services. When we purchase an

asset, for example, a personal computer, for a sum of Rs. 50,000, what we are

buying really is the services of the computer that we shall be getting over its

estimated life span, say 5 years. It will not be fair to charge the whole amount

of Rs. 50,000, from the revenue of the year in which the asset is purchased.

Instead, that part of the asset which has been consumed or used during a

period should be charged from the revenue of that period. The assumption

regarding continuity of business allows us to charge from the revenues of a

period only that part of the asset which has been consumed or used to earn

that revenue in that period and carry forward the remaining amount to the

next years, over the estimated life of the asset. Thus, we may charge

Rs. 10,000 every year for 5 years from the profit and loss account. In case the

continuity assumption is not there, the whole cost (Rs. 50,000 in the present

example) will need to be charged from the revenue of the year in which the

asset was purchased.

2.2.4 Accounting Period Concept

Accounting period refers to the span of time at the end of which the financial

statements of an enterprise are prepared, to know whether it has earned profits or

incurred losses during that period and what exactly is the position of its assets and

liabilities at the end of that period. Such information is required by different users

at regular interval for various purposes, as no firm can wait for long to know its

financial results as various decisions are to be taken at regular intervals on the

basis of such information. The financial statements are, therefore, prepared at

regular interval, normally after a period of one year, so that timely information is

made available to the users. This interval of time is called accounting period.

The Companies Act 1956 and the Income Tax Act require that the income

statements should be prepared annually. However, in case of certain

situations, preparation of interim financial statements become necessary.

For example, at the time of retirement of a partner, the accounting period

can be different from twelve months period. Apart from these companies

whose shares are listed on the stock exchange, are required to publish

quarterly results to ascertain the profitability and financial position at the

end of every three months period.


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Test Your Understanding - I

Choose the Correct Answer

1. During the life-time of an entity accounting produce financial statements in

accordance with which basic accounting concept:

(a) Conservation

(b) Matching

(c) Accounting period

(d) None of the above

2. When information about two different enterprises have been prepared presented

in a similar manner the information exhibits the characteristic of:

(a) Verifiability

(b) Relevance

(c) Reliability


3. A concept that a business enterprise will not be sold or liquidated in the near

future is known as :

(a) Going concern

(b) Economic entity

(c) Monetary unit


4. The primary qualities that make accounting information useful for decision-making

are :

(a) Relevance and freedom from bias

(b) Reliability and comparability

(c) Comparability and consistency


2.2.5 Cost Concept

The cost concept requires that all assets are recorded in the book of accounts

at their purchase price, which includes cost of acquisition, transportation,

installation and making the asset ready to use. To illustrate, on June 2005,

an old plant was purchased for Rs. 50 lakh by Shiva Enterprise, which is into

the business of manufacturing detergent powder. An amount of

Rs. 10,000 was spent on transporting the plant to the factory site. In addition,

Rs. 15,000 was spent on repairs for bringing the plant into running position

and Rs. 25,000 on its installation. The total amount at which the plant will be

recorded in the books of account would be the sum of all these, i.e.

Rs. 50,50,000.

The concept of cost is historical in nature as it is something, which has

been paid on the date of acquisition and does not change year after year. For

example, if a building has been purchased by a firm for Rs. 2.5 crore, the


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2 8 Accountancy

purchase price will remain the same for all years to come, though its market

value may change. Adoption of historical cost brings in objectivity in recording

as the cost of acquisition is easily verifiable from the purchase documents.

The market value basis, on the other hand, is not reliable as the value of an

asset may change from time to time, making the comparisons between one

period to another rather difficult.

However, an important limitation of the historical cost basis is that it does

not show the true worth of the business and may lead to hidden profits. During

the period of rising prices, the market value or the cost at (which the assets

can be replaced are higher than the value at which these are shown in the

book of accounts) leading to hidden profits.

2.2.6 Dual Aspect Concept

Dual aspect is the foundation or basic principle of accounting. It provides the

very basis for recording business transactions into the book of accounts. This

concept states that every transaction has a dual or two-fold effect and should

therefore be recorded at two places. In other words, at least two accounts will

be involved in recording a transaction. This can be explained with the help of

an example. Ram started business by investing in a sum of Rs. 50,00,000 The

amount of money brought in by Ram will result in an increase in the assets

(cash) of business by Rs. 50,00,000. At the same time, the owners equity or

capital will also increase by an equal amount. It may be seen that the twoitems that got affected by this transaction are cash and capital account.

Let us take another example to understand this point further. Suppose

the firm purchase goods worth Rs. 10,00,000 on cash. This will increase an

asset (stock of goods) on the one hand and reduce another asset (cash) on the

other. Similarly, if the firm purchases a machine worth Rs. 30,00,000 on

credit from Reliable Industries. This will increase an asset (machinery) on the

one hand and a liability (creditor) on the other. This type of dual effect takes

place in case of all business transactions and is also known as duality principle.

The duality principle is commonly expressed in terms of fundamental

Accounting Equation, which is as follows :

Assets = Liabilities + Capital

In other words, the equation states that the assets of a business are always

equal to the claims of owners and the outsiders. The claims also called equity

of owners is termed as Capital(owners equity)and that of outsiders, as


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Liabilities(creditors equity). The two-fold effect of each transaction affects in

such a manner that the equality of both sides of equation is maintained.

The two-fold effect in respect of all transactions must be duly recorded in

the book of accounts of the business. In fact, this concept forms the core of

Double Entry Systemof accounting, which has been dealt in detail, in

chapter 3.

2.2.7 Revenue Recognition (Realisation) Concept

The concept of revenue recognitionrequires that the revenue for a business

transaction should be included in the accounting records only when it is

realised. Here arises two questions in mind. First, is termed as revenueand

the other, when the revenue is realised. Let us take the first one first. Revenue

is the gross inflow of cash arising from (i) the sale of goods and services by an

enterprise; and (ii) use by others of the enterprises resources yielding interest,

royalties and dividends. Secondly, revenue is assumed to be realised when a

legal right to receive it arises, i.e. the point of time when goods have been sold

or service has been rendered. Thus, credit sales are treated as revenue on the

day sales are made and not when money is received from the buyer. As for the

income such as rent, commission, interest, etc. these are recongnised on a

time basis. For example, rent for the month of March 2005, even if received in

April 2005, will be taken into the profit and loss account of the financial year

ending March 31, 2005 and not into financial year beginning with April 2005.Similarly, if interest for April 2005 is received in advance in March 2005, it

will be taken to the profit and loss account of the financial year ending

March 2006.

There are some exceptions to this general rule of revenue recognition. In

case of contracts like construction work, which take long time, say 2-3 years

to complete, proportionate amount of revenue, based on the part of contract

completed by the end of the period is treated as realised. Similarly, when

goods are sold on hire purchase, the amount collected in installments is treated

as realised.

2.2.8 Matching Concept

The process of ascertaining the amount of profit earned or the loss incurred

during a particular period involves deduction of related expenses from the

revenue earned during that period. The matching concept emphasises exactly

on this aspect. It states that expenses incurred in an accounting period should

be matched with revenues during that period. It follows from this that the


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like SEBI, also mandates complete disclosures to be made by the companies,

to give a true and fair view of profitability and the state of affairs.

2.2.10 Consistency Concept

The accounting information provided by the financial statements would be

useful in drawing conclusions regarding the working of an enterprise only

when it allows comparisons over a period of time as well as with the working

of other enterprises. Thus, both inter-firm and inter-period comparisons are

required to be made. This can be possible only when accounting policies and

practices followed by enterprises are uniform and are consistent over the

period of time.

To illustrate, an investor wants to know the financial performance of an

enterprise in the current year as compared to that in the previous year. He

may compare this years net profit with that in the last year. But, if the

accounting policies adopted, say with respect to depreciation in the two years

are different, the profit figures will not be comparable. Because the method

adopted for the valuation of stock in the past two years is inconsistent. It is,

therefore, important that the concept of consistency is followed in preparation

of financial statements so that the results of two accounting periods are

comparable. Consistency eliminates personal bias and helps in achieving

results that are comparable.

Also the comparison between the financial results of two enterprises would

be meaningful only if same kind of accounting methods and policies are adopted

in the preparation of financial statements.

However, consistency does not prohibit change in accounting policies.

Necessary required changes are fully disclosed by presenting them in the

financial statements indicating their probable effects on the financial results

of business.

2.2.11 Conservatism Concept

The concept of conservatism (also called prudence) provides guidance for

recording transactions in the book of accounts and is based on the policy of

playing safe. The concept states that a conscious approach should be adoptedin ascertaining income so that profits of the enterprise are not overstated. If the

profits ascertained are more than the actual, it may lead to distribution of

dividend out of capital, which is not fair as it will lead to reduction in the capital

of the enterprise.

The concept of conservatism requires that profits should not to be recorded

until realised but all losses, even those which may have a remote possibility,


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3 2 Accountancy

are to be provided for in the books of account. To illustrate, valuing closing

stock at cost or market value whichever is lower; creating provision for doubtful

debts, discount on debtors; writing of intangible assets like goodwill, patents,

etc. from the book of accounts are some of the examples of the application of

the principle of conservatism. Thus, if market value of the goods purchased

has fallen down, the stock will be shown at cost price in the books but if the

market value has gone up, the gain is not to be recorded until the stock is

sold. This approach of providing for the losses but not recognising the gains

until realised is called conservatism approach. This may be reflecting a

generally pessimist attitude adopted by the accountants but is an important

way of dealing with uncertainty and protecting the interests of creditors againstan unwanted distribution of firms assets. However, deliberate attempt to

underestimate the value of assets should be discouraged as it will lead to

hidden profits, called secret reserves.

2.2.12 Materiality Concept

The concept of materiality requires that accounting should focus on material

facts. Efforts should not be wasted in recording and presenting facts, which

are immaterial in the determination of income. The question that arises here

is what is a material fact. The materiality of a fact depends on its nature and

the amount involved. Any fact would be considered as material if it is reasonably

believed that its knowledge would influence the decision of informed user of

financial statements. For example, money spent on creation of additional

capacity of a theatre would be a material fact as it is going to increase the

future earning capacity of the enterprise. Similarly, information about any

change in the method of depreciation adopted or any liability which is likely to

arise in the near future would be significant information. All such information

about material facts should be disclosed through the financial statements

and the accompanying notes so that users can take informed decisions. In

certain cases, when the amount involved is very small, strict adherence to

accounting principles is not required. For example, stock of erasers, pencils,

scales, etc. are not shown as assets, whatever amount of stationery is bought

in an accounting period is treated as the expense of that period, whether

consumed or not. The amount spent is treated as revenue expenditure and

taken to the profit and loss account of the year in which the expenditure

is incurred.

2.2.13 Objectivity Concept

The concept of objectivity requires that accounting transaction should be

recorded in an objective manner, free from the bias of accountants and others.


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This can be possible when each of the transaction is supported by verifiable

documents or vouchers. For example, the transaction for the purchase of

materials may be supported by the cash receipt for the money paid, if the

same is purchased on cash or copy of invoice and delivery challan, if the same

is purchased on credit. Similarly, receipt for the amount paid for purchase of

a machine becomes the documentary evidence for the cost of machine and

provides an objective basis for verifying this transaction. One of the reasons

for the adoption of Historical Cost as the basis of recording accounting

transaction is that adherence to the principle of objectivity is made possible

by it. As stated above, the cost actually paid for an asset can be verified from

the documents but it is very difficult to ascertain the market value of an assetuntil it is actually sold. Not only that, the market value may vary from person

to person and from place to place, and so objectivity cannot be maintained if

such value is adopted for accounting purposes.


Fill in the correct word:

1. Recognition of expenses in the same period as associated revenues is called

_______________concept.

2. The accounting concept that refers to the tendency of accountants to resolve

uncertainty and doubt in favour of understating assets and revenues and

overstating liabilities and expenses is known as _______________.

3. Revenue is gener

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